Analyzing carbon pricing policies using a general equilibrium model with production parameters estimated using firm data

Policy simulation results of Computable General Equilibrium (CGE) models largely hinge on the choices of substitution elasticities among key input factors. Currently, most CGE models rely on the common elasticities estimated from aggregated data, such as the GTAP model elasticity parameters. Using firm level data, we apply the control function method to estimate CES production functions with capital, labor and energy inputs and find significant heterogeneity in substitution elasticities across different industries. Our capital-labor substitution elasticities are much lower than the GTAP values while our energy elasticities are higher. We then incorporate these estimated elasticities into a CGE model to simulate China's carbon pricing policies and compare with the results using GTAP parameters. Our less elastic K-L substitution leads to lower base case GDP growth, but our more elastic energy substitution lead to lower coal use and carbon emissions. In the carbon tax policy exercises, we find that our elasticities lead to easier reductions in coal use and carbon emissions.